Two Times Is Too Simplistic

We’ve heard it, you’ve heard it, everybody’s heard it: The valuation metric for RIAs is two times revenue. But here’s something else you should hear about RIA valuations: Two times is too simplistic.

And not just for its imprecision, either. It’s more like…Two times revenue is wrong. It can be too high, in some cases, but for well-run firms it is often too low. Dramatically too low.

But it’s rarely – and we mean rarely – right. And when it is right, it tends to be in the same way that a stopped clock is right two times a day – pure coincidence.

How can a widely-known industry metric be so wrong? Rules of thumb are based on real thumbs, aren’t they?

Well…no. Not in this case. And it feels like high time the industry began to wrap its head around the real drivers of valuation in the wealth management business.

Where Does Two Times Come From, Anyway?
So where does this two times revenue number come from, and how did it get to be industry shorthand?

The answer is that it’s a lazy man’s number – a kind of investment banker-generated construct that tries to paper over a deep lack of information with faux back-of-the-envelope-calculation wallpaper.

Start with the fact that hard data on wealth manager deals is hard to come by, as such transactions are subject to virtually no economic disclosures. You’ll never see the spreadsheet with the last twenty transactions and all the relevant firm metrics and dollar amounts, because it doesn’t exist – certainly not in accurate form.

That paucity of information, augmented occasionally by self-reported survey data that is often more about fueling egos than about revealing industry truths, leaves us with the Shakespearean notion of “a tale told by an idiot, full of sound and fury, signifying nothing.”

It could be that uninformed buyers and sellers get together at around two times revenue because of the mythical rule of thumb, but if that’s all the attention a seller is paying to valuation methodology, two times is all they deserve.

So What's The Right Rule Of Thumb?
It’s a question we are sometimes asked – but the inquiry falsely presumes that a simple but accurate metric exists. Let’s just cut off all the thumbs and abandon the concept.

Here’s the reality: If a geographically proximate acquisition is integrated effectively and efficiently, an acquiring firm can expect to realize somewhere in the neighborhood of a 67 percent to 75 percent contribution margin. So for example’s sake, a well-run firm acquiring another wealth manager with revenues of $5 million should be able to realize an additional $3.35 million to $3.75 million of earnings.

So if you can get that much contribution from an acquisition, what should you be willing to pay for it? The two times revenue nonsense suggests all you should be willing to pay is $10 million – with only a portion paid upfront and the remainder contingent on future outcomes. But that’s less than three times the earnings contribution you’d get from the acquired firm.

In any other industry in our solar system, if you suggested to an acquisition target from which you or any other well-run firm could realize an additional $3.5 million or so in marginal contribution that, in aggregate, the most you’d pay for them was three times the contribution – regardless of what revenue multiple it represented – you’d be shown the door, quickly and with extreme prejudice.

The fact is that in competitive M&A markets, transaction valuations are based entirely on prices at which buyers can get a rational return on their investments. Consequently, winning bidders tend to be those firms who can maximize the contribution margin from an acquisition.

Of course, both the seller and buyer share in the incremental value that is created. But it would not be unusual, in other recurring revenue industries, to see deals getting done at multiples of 8x to 9x of initial expected contribution margin. For our little $5 million revenue/$3.5 million contribution margin deal, that’s six times revenue (keeping in mind that, under “market” terms for wealth managers,, such an amount would be broken into a closing payment and one or more post-closing payments tied to client retention and future growth).